Why estimating the price of oil is a calculated guess

Last week, I had a visit from an earnest young lieutenant in the Abu Dhabi Defence Force who wanted my opinion on the price of oil. "I need to know, because it is the future of my country," he told me. Flattered to be mistaken for an oracle, I had to tell him I could not explain current oil prices, which have become divorced from oil supply and demand, much less predict where crude would stand in a year or even a month from now. Much would depend on the timing and speed of economic recovery, I suggested, and on what oil traders collectively thought about that.

My visitor said he knew all was in Allah's hands, but when would the economy buck up? Again I could not help him. Never before in my lifetime had banks stopped lending money to each other and everyone, everywhere stopped buying things. The resulting downwards economic spiral was unprecedented and anybody trying to figure out how it would end was groping in the dark. I certainly did not know. Nor, in my opinion, did anyone else.

The young Emirati sincerely thanked me for these less than profound insights and left The National's newsroom deep in thought. The next day, a news agency reported that the United States Oil Fund (USO), the first and so far only exchange-traded investment fund that buys crude oil futures contracts, had denied causing last year's record peak and subsequent collapse in oil prices. That was odd, because no one had suggested it had done any such thing.

Rather, the fund was being investigated by US regulators over trading activities this year that might have widened the record price spread between contracts for oil delivery in consecutive months. That, in turn, could briefly have raised the financial incentive for traders holding physical barrels of crude to store them for later sale. What the USO actually said in a filing with the US Securities and Exchange Commission was that analyst reports alleging its buying and selling activities were causing unusually wide price swings "mischaracterised" the fund's impact on the market price of oil. The probe itself was also strange, because there had been no suggestion that the USO had intended to manipulate oil prices or had broken the law.

The fund's most contentious practice of "rolling" its holdings in an expiring crude oil future into the contract for the subsequent month is standard among "paper" traders, who have no interest in the messy business of taking physical delivery of crude. But because the USO's paper holdings are so much bigger than those of other traders, the large volume of buying and selling over a short period entailed by its rolls can significantly drive down the price of the expiring contract while lifting the price of the next-month contract.

In late February, the USO sold off 20 per cent of the outstanding March crude futures on the New York Mercantile Exchange - presumably to refiners and others who actually wanted the oil - upsetting the market. The USO is under investigation because it is the world's biggest trader in certain futures contracts, and not for doing anything illegal. A finding that its activities increase oil price volatility could therefore be taken as an argument for restricting all trading in oil futures.

Another US regulatory body, the Commodity Futures Trading Commission, is planning hearings over the next two months on just that issue. This is viewed as part of the Obama administration's effort to stabilise financial markets and could result in restrictions on "speculative trading", possibly through limiting the quantity of energy futures contracts that an institution may hold. That would be bad news for the USO, but would it help oil companies groping for a reliable crude-price forecast on which to base investment decisions? Would it help oil-exporting countries achieve more stable government revenues, or consuming nations protect their citizens from unexpected jumps in fuel costs?

Maybe not by much, because in the long run price volatility is only noise. Supply and demand still determine the signal of rising and falling price trends. Only a glut of oil can feed a sustained build-up in crude inventories, not a fleeting drop in prices, however exaggerated. Less noise might help energy planners discern the signal but so would strengthening the signal. The latter requires, among other things, greater transparency over oil production and output capacity from governments that like to keep such information secret. Strangely enough, such governments are quick to denounce "speculators" who guess at the status of supplies.

For traders uncomfortable with analysing imperfect supply and demand data, there are other means to predict short-term price moves in noisy markets. Some come from the esoteric world of technical analysis and involve mathematical concepts such as the Fibonacci series. Exactly what an abstract sequence of numbers derived from adding together sequential integers has to do with oil prices escapes this oracle's understanding, and possibly that of most commodity traders. But those who have figured it out believe they can make money from the knowledge, or from convincing others that they can.

What is left for the rest of us? Analysing tea leaves, as more than one colleague has suggested? Or perhaps in this dismal economy, designers should abandon their devotion to consumer trifles such as high-definition TV, and instead develop a high-definition crystal ball. @Email:[e-mail]